Financial Management, Capital Structure - Assignment Example

Financial Management Part A Capital structure is the way by which a business finances its assets through combining debt, hybrid security or equity (Saad, 2010). A company capital structure is the composition of its structure or liability. The Capital structure can be well understood through an example; a company that sells an equity of 30 billion dollars and a debt of 70 billion dollars. This company can be said to be 70 percent debt- financed and 30 percent equity- financed. The companys ratio of total financing to debt 80 percent is called the company leverage. In the real life situation, capital structure may be very complex and include various sources. The Gearing Ratio is the capital proportion employed by the company which comes from outside the business to taking a short term loan. Companies can raise capital through equity or debt or a combination of both equity and debt (Fried, DeSchriver & Mondello, 2013). Each of the means differ in cost with debt a lower risk so cheaper and lower cost and equity a high risk hence demeaned higher returns. The WACC calculation shows that there is an existence of an optimal capital structure. If it is true, it will be for the interest of the company to move towards the optimal capital structure in order to increase the wealth of the shareholders. The traditional view is that because the debt is cheaper than equity. Furthermore, since lenders need a lower rate of return than an ordinary shareholder, the pre-tax profit can offset the debt interest (Marney & Tarbert, 2011). As dividends are tax deductibles, and the debt transaction cost is less than issuing shares. This would seem to mean that the company should take more debt. This would increase the companies gearing level in order for a lower WACC, which would reduce the finance overall cost. Increasing the capital gearing level will not be simple as a higher level of gearing coincides with higher financial distress risks. Too much capital structure and debt influence the prospects of the business. This is because the interest on the debt need to be settled whether a profit was made or not during that year. In addition, the company prospect and the cost of capital are dependent of the market value. The company prospect can change depending on whether investors believe it to be a success (Adams, 2006). Furthermore, it can fluctuate depending on whether it will fail to achieve the expected flow of cash. The company with a lower WACC will benefit from high gearing (Horner, D., & Mott, G. (2013). It can also bring increased to the company shareholders which can also end up increasing the WACC. The WACC can be increased by increased equity cost as shareholders demand more returns as compensation for the risk that increased the debt holds. This defeats the target that gearing is to increase the wealth of shareholders as how the shareholders perceive the high risk from increased debt can destroy value. If the company decides to raise their debt level and decrease the equity, then their will be a reduction on the WACC. However, this will cause the debt amount to be of concern to their shareholders. On the other hand, a theory developed by Miller and Modigliani that argue that the capital structure of the firm does not have any impact on WACC (Baker, Singleton & Veit, 2010). They further argue that the overall value of the company is constant. In addition, the shareholders wealth can not be enhanced by changing the debt to equity ratio and, therefore, there is no existence of the optimal capital structure. The theory by Miller and Modigliani was based on the assumption that required the company to operate in a market that is perfect. This is to mean that individual shareholders can lend and borrow as cheaply as corporations. Furthermore, there borrowing should be that of which there is no taxation and there is no existence of financial distress. The assumption provided by the two does not exist in the real world of business. This makes it hard to be believed based on their theory that an optimal structure does not exist. In the year 1963 Miller and Modigliani revised their initial research by taking tax into consideration (Brigham, 1985). The adjustment made automatically changed their theory. It resulted that debt had a major of being a tax deductible expenses that can be offset against profit. The revised theory suggests that, the best gearing level for a company interested in maximizing the wealth of shareholders is the higher which is the better. However, in the in practice, the extreme position should be avoided, and companies should borrow a level that is reasonable. The reasonable level varies differently between different companies or businesses. The reasonable levels have also changed after the recession. The level is assessed depending on the circumstances of individuals and now the market has changed. Due to change in the market, the shareholders have changed their debt perception as they have realized how irresponsible lending has destroyed most of the businesses and damaged the economy. In the year 1977, financial distress was included in the study by Miller (Baker & Martin, 2011). This study concluded that at the end WACC goes up hence retaliating back to the traditional view. However, it had no conceptual for this hence proved that an optimal capital structure does exist. The resent recession experienced due to credit crisis supports the importance of capital structure. The recession was major as a result of the individuals, banks and businesses lending irresponsibly and not being in a situation to refund the debts. In the world of today, the banks are the only financial institution that the government specifies the ratio of target leverage. After the recession that affected the central banks in twenty-seven countries, the banks have been forced to take the initiative to release the Basel III agreement. This agreement is to strengthen the banks capital requirement because the ratio that is currently set by the government does not work. The main requirement of Basel agreement will mean that the banks will have to hold seven percent of their assets against their debts. The banks currently hold two percent of their assets against their debts. For the prevention of the slow growth of the banks and another crisis, there is a need to bring down the bank leverage. To bring down the bank leverage, all the capital regulation should be abolished in order for the wealth of share holders maximization to be given the fist priority in the business (In Goodhart, 2014). The theory has finalized that an optimal capital structure can exist. However, in practical, there is possibility that there is an existence of a range of capital structure in which WACC can be minimized by the companies instead of one particular ratio of debt to equity finance. It would be seen that a company that integrates affordable and sensible levels of debts into its capital structure can enjoy the advantages of tax. These taxes will be coming from debt finance and, as a result, decreases its WACC. The enjoyment will only exist if the company does not increase its generic level to a level that will create some concerns to the shareholders. Part B For any person who needs to make an investment decision using the discount cash flow analysis. There is a need for the difference between the NPV and the IRR to be understood. However, most of the people have misunderstood these concepts in the real estate and finance. This paper will help the readers understand the dissimilarity between IRR and NPV. For better understanding of the two intervention appraisal technique, it is very important top know their definitions. After the definition, it is also important to go through some examples and conclude with the common pitfall. Net Present Value (NPV) This is an investment that shows the investor if the investment is reach the attaining the aimed yield at first investment. Furthermore, NPV quantifies the changes to the initial investment needed to attain the aimed yield assuming all the other things remains constant. Mathematically, the net present value is as follows. The sum of cash flows (C) during the holding period (N), takes a period of (n). The net present value is also discounted at the investors required rate of return (r) (Introduction to corporate finance, 2012). n /(1+r)n (Finance Formulas, 2015) Internal Rate of Return (IRR) This is the percentage rate earned at each invested dollar for every time it is invested. Investment is another word that people use to refer to IRR. IRR mainly gives the investor the means to compare different investment based on their yield. Mathematically, it can be set by equating the formulae of NPV to zero and calculating the rate (IRR) (Hunt & Andrews, 1968). 2l/ (1+IRR) l (Boundless, 2014) . Differences between IRR and NPV As shown the above formulae, the formulae of NPV are used in solving the current value of cash flow stream, given the discount rate. Furthermore, the IRR is used in solving the return rate when equating NPV to zero. It is vital to understand that IRR responds to questions about what rate of return will a person achieve, given the flowing stream of cash flows. While the NPV answer question like, what is the worth of the cash flows stream at a particular discount rate in todays dollar (Balakrishnan, Sivaramakrishnan, & Sprinkle, 2008)? Illustration of the Difference with Example Suppose a small publishing company is to be bought by JKL media. The cash flows of the future formulated by the publisher is a JKL determinant, when discounted at an annual rate of 12percent, yield a 23,500,000 present value. If the owner of the publishing is ready to sell for $20 million, the NPV of the project will be $ 3.5 million. The NPV $3,500,000 represents the value of intrinsic that is to be added to JKL Media if the acquisition is undertaken. This shows that JKL media has a positive NPV. However from a business approach, the firm should know the investment rate of return that will be generated. For this to be achieved, the firm will just recalculate the NPV equation. However this time the firm will put the factor of NPV to be equal to zero and calculate the unknown rate of discount. The rate that is provided by the solution is the project internal rate of return (IRR). For the provided above example, the IRR project could depend on the proportion and timing of the distribution of the cash flow, be equal to 17.15 percent. Therefore, JKL media given its cash flow that is projected has a project with 17.15 percent return. If JKL had projects that they could undertake with a high IRR, it would instead pursue the higher- yielding project. At this point, a person can realize that the importance of IRR measurement is established in its capacity to symbolize any return in investment opportunity. Furthermore, it compares it with other possible investment. It is vital to understand that IRR and NPV are two methods for making a decision on capital – budget. Furthermore, they can be used in choosing between alternate investment and projects when the main aim is to boost the cost of the project and maximize the wealth of the shareholders (Great Britain, 2007). Defining the method of NPV is the present value of cash outflow subtracted from the inflow presence. The result is a dollar amount that is the organization net benefit. To calculate NPV and apply its rules, it is vital the follow the provided five steps. First is the identification of all the cash outflow and inflow. Second is the determination of the right rate (r) of discount. Third is the use of the rate of discount to find the present value of all outflow and inflow cash. The Fourth is the addition of all the present value. Fifth is making a decision on the investment or project using the rule of NPV. This is to mean to say yes if NPV result is positive and no if NPV result is negative. NPV being a tool for choosing among alternates, the NRV rule will prioritize an investment with high NPV that is positive (Anderson, Barnum, Belli, Dixon, Tan & IBRD, 2001). Most of the companies majorly use Waited Average Cost of Capital (WACC) as a suitable rate of discount for capital projects. WACC is a function of a farm capital structure and the needed rate of return for these securities. CAF problem can either give a WACC or a discount rate. The example shown below provides further illustration; Example For a better illustration, a person has to assume that he or she is asked to NPV approach to deciding on either of the two projects. The weighted average cost of capital of the company is eight percent. Project one cost 7million in the upfront cost. Project one will generate an annual income of $3 million starting three years from now and continue for a period of five years. On the other hand, the cost of project two is $ 2.5 million upfront and $2 million for each of the three years consecutively. It provides no yearly profits and will be sold for 16,000,000 after six years. For each project, NPV= (inflows) – (outflows) Project One The present value of the outflows is equivalent to $7 million which is the current cost. The inflow is also seen as an allowance with the first payment in the three years. The inflow can also be viewed as ordinary annuity at t= 2. PV annuity factor for r = .07, N = 5 Therefore PV= (1 - (1 ÷ (r + 1) N) ÷r = (1 - (1 ÷ (1.07)5) ÷.07 = (1 - (1 ÷ (1.40255) ÷.07 = (1 – (1 ÷ (1.40255) ÷.07 = (0.28701) ÷.07 = 4.10014 Multiplying the value of the inflows at t=2 by the annuity payment of $ 3 million which results to $ 11,978,000. Discounting back two periods, PV inflow = ($11.978)/ (1.08)2 = $10,269,000 NPV (Project one) = ($10,269,000) - ($7,000,000) = $3,269,000 Project Two Lump sum is the inflow present value; the price for sale is discounted six years to the current. $16,000,000 ÷ (1.07)6 = $10,661,000 Cash outflow is the summations of the discount cost and the upfront costs from the first to the year that defines an allowance which is the third year. The factor for PV annuity for r = .07, N = 3: (1 - (1 ÷ (1.07)3) ÷.07 = (1 - (1 ÷ (1.225043) ÷ .07 = (0.183702) ÷ .07 = 2.624316 PV of the annuity = ($2,000,000) × (2.624316) = $5,248,000 PV of outflows = ($2,500,000) + ($5,248,000) = $7,748,632.089 NPV of Project B = ($10,661,000) - ($7,748,632.089) = $2,912,368 Applying the NPV rule, we choose Project one, which has the larger NPV: $3,269,000 versus $2,912,368. The Internal Rate of Return As initially defined, the internal return rate is the rate of discount that makes NPV equal to zero. Like the NPV, IRR, also starts by identifying the all cash outflow and inflow. However instead of IRR depending on the data that is external, the IRR is the main outflow and inflow factor of the project. The rule of IRR states that, investments or projects are acceptable when the IRR project exceeds a rate of a hurdle. Depending on the application, the rate of hurdle can be identified as the weighted average cost of capital (Jensen & ICARRAH, 2000). Example 2 What if the project cost $10 million today and is in a position to provide a payoff of $15 million for a period of three years from today. In this point, a person uses FV of the formulae for single sum and solve for r to calculate the IRR. IRR = -1 + (FV÷ PV) 1÷N = -1 + (15,000,000/10,000,000) 1÷3 = (1.5) 1÷3 - 1 = -1+ (1.1447) = 0.1447 In this calculation, we green light the project as provided the rate of hurdle is fewer than 14.47%. NPV vs. IRR For each of the rules used for making a decision in capital budgeting has its weakness and strength. The rule of the NPV chooses a project in terms of net finance or net dollar impact on the company. This makes it easy to use when allocating capital. However, it needs an assumed rate of discount. It also assumes that the rate of percentage will be stable over the projects life. Furthermore, it assumes that cash flow can be reinvested at the same rate of discount. In the practical world, this assumption can be broken down in times when there is a fluctuation of the interests. The appeal of the rule of IRR is that there is no need of assuming as the investment cost is mainly the outflow and internal inflows function of that a given paretic investment. However, IRR does not review the impact of financial on a firm; it only needs meeting a least amount return rate. NPV and IRR methods can categorize projects differently depending on the investment size. Considering two projects one and two; project one has a first outflow of $ 250,000 and the amount to be paid of is $280,000 which should be after one year. The calculate IRR is 12% and NPV is positive $ 14,151. The second project which is project two has a first outflow of $ 50,000 and the amount to be paid of is $60,000 which should be after one year. The calculate IRR is 20% and NPV is positive $ 6,604. By the rule of NPV we select Project one, and by the rule of IRR we desire two. How do we decide the difference if we are to settle on one project? The rule is to use NPV when the two methods are incompatible. This is because it reflects to grow the companies’ financial wealth. Consequences of the use of the IRR Method Small projects or investments can have IRRS that is higher but will have a financial impact that is less. The IRR method is also affected by the timing of the cash flows. Considering the table below in which the initial investments are equal. Project one has a low NPV. 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